What’s it: Perfect competition is a theoretical market structure concept with many companies producing identical goods or services. In other words, each company offers goods that substitute each other entirely.
Also called perfect competition.
Perfect competition characteristics
Perfect competition depends on several hypotheses. Consequently, you probably won’t see it in the real world.
Perfect competition is characterized by:
- There are many sellers and buyers in the market
- Companies have small size and market share
- Companies produce homogeneous products
- Switching costs are minimal, allowing consumers to freely switch products.
- The information must be perfect and complete
- Companies are challenging to achieve a competitive advantage
- The entry and exit barriers are low
- The firm acts as a price taker and does not have the power to set prices (pricing power)
- There is no non-price competition in the market
- In the long run, each firm produces normal profits, and it is unlikely that it will generate economic profit
Small company size and market share
The perfect competition market is highly fragmented with many small firms. Competing firms are approximately equal in size and resources.
The supply of each firm is minimal compared to the overall market output. Thus, firms cannot influence prices through output limitations.
Each firm can sell as much output as it wants at market prices.
Homogeneous product and low switching costs
Buyers make purchasing decisions based solely on price because the products on the market are homogeneous.
Each of these companies sells identical products in terms of features and quality. Hence, buyers cannot differentiate between products based on physical attributes, such as size or color, or intangible value, such as brand.
Because the product is homogeneous, consumer loyalty is zero.
That is why, in this market, the products in the market are substituting perfectly. Switching costs are minimal. Consumers will easily turn to competitors if one company tries to increase prices.
Consumers and companies have the same market information to make their respective decisions. It includes related to supply, demand, and market prices.
Information is freely and equally available to all companies. This ensures that each company produces goods or services identically.
Difficulty achieving competitive advantage
Companies in perfect competition find it challenging to achieve a competitive advantage even for a while. They can only strike a competitive balance.
This market assumes no differentiation. The cost leadership strategy does not apply either. Any higher profit will attract new players in and push down the market price. Finally, the company cannot enjoy long-term economic profits.
Low market entry and exit barriers
Companies can freely spend their labor and capital assets without restrictions. They can easily adjust their output concerning market demand.
Any company can exit the market whenever they want, without incurring additional costs. The company only makes enough profit to stay in business and nothing more.
If they make excess profits, other firms will enter the market and reduce profits. New entry threats also increase efficiency by forcing existing firms to minimize costs or otherwise be forced out of the market.
The company acts as a price taker.
The company has no power over the price of the product it sells. As a result, they must set their price at the market price.
The equilibrium of market supply and demand is the sole determinant of the selling price for all firms.
The difference between perfect competition, monopolistic competition, and monopoly
Perfect competition is a theoretical market structure and is difficult to find in the real world.
In terms of the firm’s influence on market supply, perfect competition is the opposite of a monopoly.
Under perfect competition, firms have no power over market supply. That’s because their production size is tiny. As a result, they can’t influence market prices by changing the output level.
In contrast, under a monopoly, one firm supplies goods or services for the entire market. The monopolist has full power over the market supply and over the price and quality of output. Monopolists can impose any price they want because consumers have no alternative. It is difficult for potential competitors to enter the market.
Meanwhile, the monopolistic competition markets a little bit similar to the perfect competition market. Perfect competition and monopolistic competition are market structures that consist of many sellers and buyers.
But, in monopolistic competition, firms have some market power. They have the opportunity to differentiate the products offered, either through advertisements, brands, or product quality. Differentiation allows some firms to generate higher profits than others.
Examples of a market close to perfect competition
In the real world, perfect competition is impossible for you to find.
Almost all markets are imperfect competition. In that market, companies have market power, ranging from few to absolute. Some are monopolistic competition with relatively differentiated products. While the others are oligopoly or monopoly.
Well, if I give possible examples, an auction, in which several sellers try to sell an identical item to several buyers, is close to perfect competition. Other examples are the foreign exchange market and commodities, such as agricultural products.
But, in such a market, there may be several large players who can influence prices, particularly in terms of supply volume.
Equilibrium in perfectly competitive markets
In the short run, firms in the perfect competition might generate economic profit, economic loss, or normal profit. In each scenario, the firm produces a level of output where marginal cost equals marginal income.
Whether to make a profit or loss depends on the demand curve’s position relative to the average cost on the profit-maximizing quantity.
If the price is higher than the average cost, the company generates economic profit. If the price is equal to the average cost, the firm will only earn a normal profit. Meanwhile, economic losses arise when prices are lower than average costs.
In the long run, all firms in the perfect competition will only generate normal profits.
Each company will produce output at the minimum average total cost. If the company generates economic profits in the short term, new entrants will enter the market, increasing supply. This will force market prices down until only normal profits are earned by all firms.
If the companies incur economic losses in the short term, some of them will leave the industry over time. That reduces market supply. The price will increase until a normal profit is generated by all the remaining firms.
The price will equal the minimum average cost, and in the long run, there will be no economic profit. Firms will still produce a level of output where marginal cost equals marginal income and continue to work to reduce their costs.
Therefore, marginal cost will equal marginal profit in the long run, which will equal market prices and average revenue. The average revenue will be at the minimum point of average cost.
The perfect competition allows efficient allocation of resources.
The perfect competition enables productive efficiency in the economy. Under this market structure, there are no externalities.
The price will always equal the minimum of the long-run average cost curve. In other words, goods are produced and sold at the lowest cost.
On the other hand, allocative efficiency can also be achieved because the marginal utility equals the marginal cost.
Marginal utility (also known as a marginal benefit) refers to the benefit a consumer receives from consuming one more good. Marginal utility represents the consumer’s willingness to pay, that is, the price of the goods.
Marginal cost is the extra cost incurred when the firm produces one more good.
In a perfect competition market, marginal cost will always equal marginal utility. If the price (marginal utility) lower than the marginal cost, it makes sense for the firm to produce a smaller quantity. Conversely, if the price is greater than the marginal cost, it is profitable for firms to increase their output.